Cryptocurrencies - Real world implications?

Virtual currencies are booming, both in value and variety, and they have very real world tax implications for investors who hold them in their digital wallets. They should be wary.

Many of those who bought bitcoins a few years ago, for example, perhaps after engaging with its complex ‘mining’ of valuable cryptocurrencies, are now sitting on significant gains; and, as a result, on potential tax liabilities.

Cryptocurrencies may still be an exotic asset class, but they are edging ever more into the mainstream, with more than 1,000 variants currently in circulation. As their popularity is growing, so is interest from tax authorities.

A key question that they are asking is just what exactly is due for something that, on paper, may never actually be on paper? Much of their thinking is still opaque, but one thing is clear, at least in the UK: invisibility will not remove liability.

The answer to the existing tax issue is at one level quite straightforward: any increase in value may attract capital gains tax or income tax as soon as the currency is disposed of, irrespective of whether there is a conversion into any other asset deemed by a government to be legal tender.

However, that is unlikely to be the end of the story. Tax authorities are still deciding much else about virtual currencies and where they should attract a charge. And the problems challenging Her Majesty’s Revenue & Customs (HMRC) as they work through the issues are complex.

At a basic level, there is the difficulty of even determining where a cryptocurrency is located. Does it rest in the country where passwords to access the cryptocurrency are physically contained? Perhaps. But some investors split the password between four different countries in order to minimise risk from hackers. Others carry their codes around with them as they travel the world. Where does that site the cryptocurrency for tax purposes?

There are other hazards, too. Anyone using cryptocurrencies to raise short term investment finance, or who appears to be buying and selling the currencies quickly, may be judged as trading and therefore liable to further taxes. This grey area between holding and trading could cause unexpected tax problems. And case law only helps at the margins of certainty, with each instance turning on its individual merits.

What is clear is that the currencies themselves are evolving faster than the tax rules, which means increasingly transactions are now between different versions of cryptocurrencies as holders seek to develop their holdings, but without the result emerging into a ‘real’ denomination. Here there is actually some light: any exchange into another virtual option could result in a capital gains tax or income tax charge.

But against a backdrop of much uncertainty, it makes sense to be transparent to tax authorities about holding cryptocurrencies. HMRC dislikes surprises, making its own discoveries about tax affairs, or self-serving assumptions about disclosure. Cryptocurrencies invite all three possibilities. It is far better to declare a holding whilst HMRC views about liability are forming, as form they will. Full disclosure before any liability will be viewed more favourably than one extracted later should a financial reckoning be due.

It is not just an issue of income, either. There are other risks that could also impact on what it costs to hold or sell cryptocurrencies. One of these is the huge amount of energy needed to produce them. It is not inconceivable that governments may slap a tax on bitcoin production on environmental grounds.

What is, however, quite clear is that cryptocurrencies are now established as an asset class, and will be treated as such. This means it is only a matter of time before more rules on taxation are in place.

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